The UK has significantly extended the scope of withholding tax as it applies to royalty payments, and is introducing new rules to target hybrid mismatches.
The UK royalty withholding and hybrid rule changes announced in the UK Budget in March 2016 have a clear policy intent. Their aim is to enable the UK to tax IP income considered to have a UK source where the recipient of the income is not treaty protected, or where the reliance on a treaty has a main purpose of mitigating the tax in a manner which is contrary to the object and purpose of the treaty. How far HMRC's ambitions might be for this measure in practice remains to be seen; there are clear indications that they see the potential for action in any structure where IP ownership is not aligned with where the 'DEMPE' functions are located - 'DEMPE' being the OECD's new term for describing functions related to IP (Development, Enhancement, Maintenance, Protection, Exploitation).
A recap of the rules in brief
The following changes have been made in relation to withholding tax:
- New anti-treaty shopping provisions based on "main purpose" in UK domestic law which override all treaties (from 17 March 2016)
- An expansion of the scope of royalties subject to UK withholding tax at the rate of 20 percent to include items such as trademark and know-how royalties and broadly align it with the internationally accepted definition of royalties (from 28 June 2016)
- A new statutory definition of source deeming that any royalty connected to a UK permanent establishment (PE) should have a deemed UK source (from 28 June 2016)
- Changes to the Diverted Profits Tax (DPT) rules to increase profits that are subject to DPT at the rate of 25 percent by the amount of royalties paid by foreign principals to non-treaty protected IP owners, where the royalty would have had a UK source had there been a real PE (from 28 June 2016)
Included are very broad-ranging anti-avoidance provisions which seek to counter certain changes made in response.
In parallel, the UK is also introducing statutory anti-hybrid rules which broadly mirror the recommendations at Action 2 of the OECD's anti-Base Erosion and Profit Shifting (BEPS) initiative, but go beyond those proposals in several key respects. These will come into effect on 1 January 2017. The rules are contained in the Finance Act 2016. They attack mismatches generated by hybridity broadly arising from countries either treating the character of a payment or the character of an entity differently.
The over-arching policy appears to be that the UK should not concede its right to tax royalty income at source unless a treaty validly shifts taxing rights to another state, in a manner consistent with the object and purpose of the treaty. It seems clear from publicly available HM Treasury notes and HMRC meetings that these changes are expected to raise revenue, rather than being a driver for behavioural change, which was the original policy objective of the DPT. This expectation of increased tax take is of particular relevance when considering the potential application of the various anti-avoidance rules introduced in the above changes. The changes mean that the DPT is no longer confined to ensuring that profits properly attributable to UK activities are appropriately rewarded, but is a tax grab on so-called "nowhere income", even where there are no UK DEMPE functions relating to IP.
The anti-avoidance rules
The existence of anti-avoidance rules will inevitably create some uncertainty even where trading structures are being introduced or modified for a wide variety of reasons. There are several new anti-avoidance rules to consider:
- The anti-treaty shopping rule (s.917A ITA 2007): this introduces a 'main purpose' test override to all double tax treaties along the lines seen in some UK treaties since the early 1990s. A main purpose of taking advantage of the tax treaty must be contrary to the objectives of the treaty in order for the override to have effect. This definition is proving problematic because commercial arrangements which take advantage of a treaty might not be economic absent that treaty. Would this constitute a main purpose? HMRC have said they will follow the OECD commentary which relates to the use of the term in the new model treaty. In particular, HMRC have said they will target conduit arrangements.
Of most interest to taxpayers considering moving IP to an 'onshore' location is HMRC's suggestion in their 27 June guidance that this might still trigger the avoidance test 'if, on the facts of the case, one of the main purposes of the transfer of the IP was to obtain a tax advantage by virtue of a provision of the treaty'. Furthermore, it is suggested that this may apply 'even if the affiliate [in the treaty country] had a large R&D function of its own'. It is unclear how this sits with later commentary confirming that the treaty should be respected if the income is taxed there consistently with the object and purpose of that treaty. It seems that HMRC's preparedness to test the reason for any change to royalty payments may place groups at a disadvantage if their starting point leaves them subject to withholding tax under the new rules.
- The rules extending what payments are subject to withholding tax contain an anti-avoidance provision which targets amounts prepaid before 28 June 2016 when they were originally due after that date.
- The final anti-avoidance rule provides that arrangements with a main tax avoidance purpose of ensuring that income does not have a UK source for the purposes of these rules must be disregarded. For example, a group may wish to respond to the rules by converting its UK activities into a reseller so that there is no longer a PE and therefore no longer a UK source subject to withholding tax. It seems clear that HMRC are going to scrutinise the purpose behind any such move extremely carefully and seek to ignore it if they suspect avoidance.
Where does this leave groups potentially subject to UK withholding tax following the rule changes?
The changes have led to some commentators suggesting that there is little that can be done if a group's current trading model suffers UK withholding tax under the new rules. It is certainly reasonable to suggest that any change which reduces the amount of UK withholding tax is likely to be scrutinised carefully but we don't believe that the rules make it impossible to ever modify a trading model. The options available in response of course vary according to individual commercial circumstances. A UK-focused response is likely to come under the greatest scrutiny from HMRC. Instead, many groups may regard UK changes as one of a range of factors which they should take into account in considering the overall landscape in which modifications to trading models are made.
Many groups may not be directly impacted by withholding tax but instead by the corresponding changes to the DPT rules which increase profits attributable to 'notional' UK PEs. Many groups have got comfortable on their DPT position in DPT's first year of operation by stress testing their transfer pricing and profits that would be allocated to a deemed UK PE, but the new DPT charge totally changes the landscape.
It is also important to recognise the interaction with the new anti-hybrid rules. For many, the focus of these rules has been on interest payments but they apply equally to payments such as royalties and costs of goods sold. Anyone continuing to own IP in a 'hybrid entity' will need to consider these rules carefully. The UK Government's perspective on what constitutes a "hybrid" for these purposes has continued to expand, and it can now include a checked tax haven entity that is not subject to corporate income tax.
What is an appropriate response?
For many, deciding how to respond to these changes is raising challenging questions which are not answered easily but are nonetheless urgent, given the effective date of the new rules.